Leveraged Buyout

Structures and Valuation

 M & A an d O th er
R e s tr u c t u ri n g
A c ti v i ti e s

M & A M & A P roce ss Deal A lte r n a t iv e

E n v ir o n m e n t S t ru c tu r i n g R e s tr u c t u r in g
S tr a t e g ie s

M o ti v a ti o n s B u s in e s s & P u b l ic & D iv e s t i t u r e s ,
fo r M & A A c q u i s itio n P l a n s P r iv a t e C o m p a n y S p i n - O ff s , &
V a l u a ti o n C a rv e - O u t s

C o m m o n T a ke o ver S e a r c h T h ro u g h F in a n c ia l B an kru p tcy &

T a c ti c s a n d C l o s i n g A c t i v it i e s M o d e lin g L iq u id a t io n
D e fe n s e s T e c h n iq u e s

A l t e r n a t iv e
S t r u c tu r e s

T a x & A c c o u n ti n g
Is s u e s
 Learning Objectives
• Primary Learning Objective: To provide students with a knowledge
of how to analyze, structure, and value highly leveraged
transactions.
• Secondary Learning Objectives: To provide students with a
knowledge of
– The motivations of and methodologies employed by financial
buyers;
– Advantages and disadvantages of LBOs as a deal structure;
– Alternative LBO models;
– The role of junk bonds in financing LBOs;
– Pre-LBO returns to target company shareholders;
– Post-buyout returns to LBO shareholders, and
– Alternative LBO valuation methods
– Basic decision rules for determining the attractiveness of LBO
candidates
 Financial Buyers
In a leveraged buyout, all of the stock, or assets, of a public
corporation are bought by a small group of investors
(“financial buyers”), usually including members of
existing management. Financial buyers:
• Focus on ROE rather than ROA.
• Use other people’s money.
• Succeed through improved operational performance.
• Focus on targets having stable cash flow to meet debt
service requirements.
– Typical targets are in mature industries (e.g., retailing,
textiles, food processing, apparel, and soft drinks)
 LBO Deal Structure
• Advantages include the following:
– Management incentives,
– Tax savings from interest expense and depreciation from asset
write-up,
– More efficient decision processes under private ownership,
– A potential improvement in operating performance, and
– Serving as a takeover defense by eliminating public investors
• Disadvantages include the following:
– High fixed costs of debt,
– Vulnerability to business cycle fluctuations and competitor
actions,
– Not appropriate for firms with high growth prospects or high
business risk, and
– Potential difficulties in raising capital.
 Classic LBO Models:
Late 1970s and Early 1980s
• Debt normally 4 to 5 times equity. Debt amortized over no
more than 10 years.
• Existing corporate management encouraged to participate.
• Complex capital structure: As percent of total funds raised
– Senior debt (60%)
– Subordinated debt (26%)
– Preferred stock (9%)
– Common equity (5%)
• Firm frequently taken public within seven years as tax
benefits diminish
 Break-Up LBO Model (Late 1980s)

• Same as classic LBO but debt serviced from

operating cash flow and asset sales
• Changes in tax laws reduced popularity of this
approach
– Asset sales immediately upon closing of the
transaction no longer deemed tax-free
– Previously could buy stock in a company and
sell the assets. Any gain on asset sales was
offset by a mirrored reduction in the value of the
stock.
 Strategic LBO Model (1990s)
• Exit strategy is via IPO
• D/E ratios lower so as not to depress EPS
• Financial buyers provide the expertise to grow earnings
– Previously, their expertise focused on capital structure
• Deals structured so that debt repayment not required
until 10 years after the transaction to reduce pressure on
immediate performance improvement
• Buyout firms often purchase a firm as a platform for
leveraged buyouts of other firms in the same industry
 Role of Junk Bonds in Financing LBOs
• Junk bonds are non-rated debt.
– Bond quality varies widely
– Interest rates usually 3-5 percentage points above the prime rate
• Bridge or interim financing was obtained in LBO transactions to
close the transaction quickly because of the extended period of time
required to issue “junk” bonds.
– These high yielding bonds represented permanent financing for
the LBO
• Junk bond financing for LBOs dried up due to the following:
– A series of defaults of over-leveraged firms in the late 1980s
– Insider trading and fraud at such companies a Drexel Burnham,
the primary market maker for junk bonds
• Junk bond financing is highly cyclical, tapering off as the economy
goes into recession and fears of increasing default rates escalate
 Factors Affecting Pre-Buyout Returns
• Premium paid to target firm shareholders consistently
exceeds 40%

• These returns reflect the following (in descending

order of importance):
– Anticipated improvement in efficiency and tax
benefits
– Wealth transfer effects
– Superior Knowledge
– More efficient decision-making
Factors Determining Post-Buyout Returns

• Empirical studies show investors earn abnormal post-

buyout returns
• Full effect of increased operating efficiency not
reflected in the pre-LBO premium.
• Studies may be subject to “selection bias,” i.e., only
LBOs that are successful are able to undertake
secondary public offerings.
• Abnormal returns may also reflect the acquisition of
many LBOs 3 years after taken public.
 Valuing LBOs
• A LBO can be evaluated from the perspective of
common equity investors or of all investors and lenders
• LBOs make sense from viewpoint of investors and
lenders if present value of free cash flows to the firm is
greater than or equal to the total investment consisting of
debt and common and preferred equity
• However, a LBO can make sense to common equity
investors but not to other investors and lenders. The
market value of debt and preferred stock held before the
transaction may decline due to a perceived reduction in
the firm’s ability to
– Repay such debt as the firm assumes substantial
amounts of new debt and to
– Pay interest and dividends on a timely basis.
 Valuing LBOs: Variable Risk Method

Adjusts for the varying level of risk as the firm’s

total debt is repaid.
• Step 1: Project annual cash flows until
target D/E achieved
• Step 2: Project debt-to-equity ratios
• Step 3: Calculate terminal value
• Step 4: Adjust discount rate to reflect
changing risk
• Step 5: Determine if deal makes sense
 Variable Risk Method: Step 1
• Project annual cash flows until target D/E ratio
achieved
• Target D/E is the level of debt relative to equity
at which
– The firm will have to resume payment of taxes
and
– The amount of leverage is likely to be
acceptable to IPO investors or strategic
buyers (often the prevailing industry average)
 Variable Risk Method: Step 2
• Project annual debt-to-equity ratios
• The decline in D/E reflects
– the known debt repayment schedule
and
– The projected growth in the market
value of the shareholders’ equity
(assumed to grow at the same rate as
net income)
 Variable Risk Method: Step 3
• Calculate terminal value of projected cash
flow to equity investors (TVE) at time t,
i.e., the year in which the initial investors
choose to exit the business.
• TVE represents the PV of the dollar
proceeds available to the firm through an
IPO or sale to a strategic buyer at time t.
 Variable Risk Method: Step 4
• Adjust the discount rate to reflect changing risk.
• The firm’s cost of equity will decline over time as debt is repaid and equity
grows, thereby reducing the leveraged ß. Estimate the firm’s ß as follows:

ßFL1 = ßIUL1(1 + (D/E)F1(1-tF))

where ßFL1 = Firm’s levered beta in period 1

ßIUL1 = Industry’s unlevered beta in period 1
= ßIL1/(1+(D/E)I1(1- tI))
ßIL1 = Industry’s levered beta in period 1
(D/E)I1 = Industry’s debt-to-equity ratio in period 1
tI = Industry’s marginal tax rate in period 1
(D/E)F1 = Firm’s debt-to-equity ratio in period 1
tF = Firm’s marginal tax rate in period 1

• Recalculate each successive period’s ß with the D/E ratio for that period,
and using that period’s ß, recalculate the firm’s cost of equity for that period.
 Variable Risk Method: Step 5

• Determine if deal makes sense

– Does the PV of free cash flows to equity
investors (including the terminal value)
equal or exceed the equity investment
including transaction-related fees?
 Evaluating the Variable Risk Method

• Advantages:
– Adjusts the discount rate to reflect diminishing
risk as the debt-to-total capital ratio declines
– Takes into account that the deal may make
sense for common equity investors but not for
lenders or preferred shareholders
• Disadvantage: Calculations more burdensome
than Adjusted Present Value Method
 Valuing LBOs: Adjusted Present Value
Method (APV)
Separates value of the firm into (a) its value as if it were debt free
and (b) the value of tax savings due to interest expense.
• Step 1: Project annual free cash flows to equity investors and
interest tax savings
• Step 2: Value target without the effects of debt financing and
discount projected free cash flows at the firm’s estimated
unlevered cost of equity.
• Step 3: Estimate the present value of the firm’s tax savings
discounted at the firm’s estimated unlevered cost of equity.
• Step 4: Add the present value of the firm without debt and the
present value of tax savings to calculate the present value of the
firm including tax benefits.
• Step 5: Determine if the deal makes sense.
 APV Method: Step 1
• Project annual free cash flows to equity investors and
interest tax savings for the period during which the firm’s
capital structure is changing.
– Interest tax savings = INT x t, where INT and t are the
firm’s annual interest expense on new debt and the
marginal tax rate, respectively
– During the terminal period, the cash flows are
expected to grow at a constant rate and the capital
structure is expected to remain unchanged
 APV Method: Step 2
• Value target without the effects of debt financing and
discount projected cash flows at the firm’s unlevered
cost of equity.
– Apply the unlevered cost of equity for the period
during which the capital structure is changing.
– Apply the weighted average cost of capital for the
terminal period using the proportions of debt and
equity that make up the firm’s capital structure in the
final year of the period during which the structure is
changing.
 APV Method: Step 3
• Estimate the present value of the firm’s annual
interest tax savings.
– Discount the tax savings at the firm’s
unlevered cost of equity
– Calculate PV for annual forecast period only,
excluding a terminal value, since the firm is
sold and any subsequent tax savings accrue
to the new owners.
 APV Method: Step 4
• Calculate the present value of the firm
including tax benefits
– Add the present value of the firm without
debt and the PV of tax savings
 APV Method: Step 5

• Determine if deal makes sense:

– Does the PV of free cash flows to equity
investors plus tax benefits equal or
exceed the initial equity investment
including transaction-related fees?
 Evaluating the Adjusted Present
Value Method
• Advantage: Simplicity.
• Disadvantages:
– Ignores the effect of changes in leverage on
the discount rate as debt is repaid,
– Implicitly ignores the potential for bankruptcy
of excessively leveraged firms, and
– Unclear whether true discount rate should be
the cost of debt, unlevered cost of equity, or
somewhere between the two.
 Things to Remember…
• LBOs make the most sense for firms having stable cash flows,
significant amounts of unencumbered tangible assets, and strong
management teams.
• Successful LBOs rely heavily on management incentives to improve
operating performance and a streamlined decision-making process
resulting from taking the firm private.
• Tax savings from interest expense and depreciation from writing up
assets enable LBO investors to offer targets substantial premiums
over current market value.
• Excessive leverage and the resultant higher level of fixed expenses
makes LBOs vulnerable to business cycle fluctuations and
aggressive competitor actions.
• For an LBO to make sense, the PV of cash flows to equity holders
must equal or exceed the value of the initial equity investment in the
transaction, including transaction-related costs.